529s and ESAs — the nitty-gritty of saving for college

Charlie lives with his wife and three daughters outside of San Francisco. He runs PearBudget, enjoys being outdoors, and really loves a good library.

A couple of years ago, I was reading an article about money and sending kids to college. “Blah blah blah,” it went (more or less), “and you should stick the money in a 529.”

“Oh, man,” I remember thinking. “A ‘529’? What the heck is that?” I got really concerned, and looked into it. I found some websites, created by out-of-breath journalists, telling me that college costs were rising, that I’d need to sell my kidneys on the black market to afford tuition for my kids, and that because I didn’t have a 529, I didn’t like my kids and clearly wanted them to have a terrible life.

I got so concerned, in fact, I opened TWO of these mysterious “five-two-nines,” despite the fact that — at the time — I didn’t actually even have any kids.

Clearly that was the right call, right? I mean, I liked my kidneys. And I liked my non-existent kids. And surely investing in their education was what I needed to do, right? Well … maybe not.

Today we’re going to look at this mysterious creature, the 529, and its cousin, the ESA. What are they? Does your family need one? Is one of them better than the other? How do you set one up? When should you set one up? And if you don’t have one, does that mean you secretly don’t like your kids?

What are 529s, anyway?

529s are a good thing. But — just to get this out of the way — if you don’t have one, you probably still like your kids.

A 529 is simply a fancy way of saying “a special savings account for college expenses.” Think of them as a retirement fund for your kid’s college: you invest money now in a mutual fund, and when it’s time to use the money to pay for college, the money will hopefully have increased, and you won’t have to pay any tax on that increase. And as a bonus, you can pay less in state taxes right now by putting money into a 529.

There’s actually a second kind of 529, but it’s less common. Basically, it lets you buy tuition credits down the road at today’s prices. The only downside — you have to pay them now. This kind of plan usually makes sense if your child is currently in high school, as it’s less risky than the other kind of 529. If your child goes to an out-of-state or private school, the state pays that school whatever the going rate for your in-state tuition is. If you want to look into these, just search Google for “prepaid tuition + [your state].”

You don’t have to invest in your state’s plan, and just because you put your money into one state’s plan doesn’t mean you have to send your kids to a school in that state. Plus, you aren’t limited to just public schools — 529s can be used for just about any college or university in the US (and several outside the country). You can search the list of schools here.

And ESAs? What are they?

An ESA, or an Educational Savings Account, is like a 529; it’s simply a “retirement fund” for college savings.

There are benefits and drawbacks to using ESAs rather than 529s. For example, you can’t start an ESA once a child is 18 years old, and ESAs have to be used before the child is 30. For many people, that isn’t a problem. For others, it might be. There are some contribution limits for ESAs that might not work for some folks. And ESAs don’t give you tax benefits in the current year the way 529s do.

But there are some advantages to ESAs as well. You can withdraw funds from the ESA for private middle school or high school costs in addition to college (529s are limited to college and graduate school). Also, you can invest your ESA in a much wider variety of funds than you can with a 529.

The options given by 529s are probably broad enough for the vast majority of parents, but if you want extra control, an ESA might be a better match for you.

Should I go with ESAs or 529s? And which fund should I pick?

It’ll depend on how much you plan to invest, how long you have until your child enters college, what types of funds you’d like to invest in, which state you live in, and a few other factors.

Dave Ramsey encourages people to go with ESAs at first, and to then go with 529s if ESAs don’t fully meet their needs. One of the benefits to this strategy is that there’s more flexibility to the funds, stocks, or bonds you can pick. Keep in mind, though, that there are drawbacks to going with ESAs, and 529s might be better for you.

From the standpoint of wanting something simple, and wanting to get started with something, I’d look into my state’s options for 529s. If I liked the investment options it gave, I’d go with one of them. If not, I’d go with an ESA.

How do I open a 529 or ESA?

The actual process of opening an account is easy. It mostly involves filling out a form and sending in a check. You can also set up regular, automatic deposits from your bank account. (They like to make it easy for you to contribute.)

You can create an account for each of your children if you’d like to. But you might decide to do what I did when I created mine, and to list yourself as the beneficiary. (You might recall that when I set my accounts up, I didn’t have any children, so I had to name myself as the beneficiary.) As my daughters get closer to college, I’ll convert it over.

If you opt for this approach, be sure to investigate the rules for your state regarding 529 ownership transfers. Usually, they aren’t bad, but you want to make sure you don’t have unnecessary hoops to jump through.

But before you get to that, you should think about whether it even makes sense for you to put money into a “College Retirement Fund” at all.

Should I open a college savings account right now?

It depends.

Obviously, if your kids aren’t going to go to college, it’s not necessary. But you probably already figured that out. It depends on some other things, as well. Namely: is the rest of your financial house “in order”?

I really like Dave Ramsey’s advice on when to save for college. He says that your first priorities should be to have a cushion of savings in the bank, to pay off your debts, and to set aside money for your retirement (he recommends 15% of your income). According to Dave, you should be doing all three of those things before setting aside money for your kids’ college.

Here’s a quick rundown:

• Do you have at least $1,000 in the bank, available for “little” emergencies? If not, take care of that first. If so …

• Do you have any debts? If so, pay them off. If not …

• Do you have 3+ months of living expenses in the bank? If not, it’s a good idea to set money aside, in case you lose a job or have some other larger financial emergency. If so …

• Are you already setting aside 15% of your income for retirement? If not, focus on that. If so…

Congratulations! You can start thinking about saving for your kids’ college expenses.

So, as you can see, for a lot of us (myself included), there are a number of other things we need to do before we worry about saving for college. I’m not going to close my existing 529 accounts, but I don’t plan to put any more money towards them until I’ve got more money in the bank and am putting more of my income towards retirement.

If you have any questions about college savings plans, there’s a useful website at Saving For College that has a list of frequently-asked questions.

So what are you wondering about regarding college savings? Have you already started saving for your children to go to college? What tips can you share with other SimpleMom readers, to make the process smoother?

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Comments

We have a Fidelity Investments credit card (that we pay off every month) that puts 2% into a 529 plan for is of whatever amount we spend. We put everything on the card so we get about $50 a month into our kids’ 529s. Will it be enough? For us, probably not with three kids going to college within 12 months of each other. But, it is a start. And “free” money.

For people using credit cards (and, like you, paying them off!), a reward card like this can be a great way to get funds into a college savings account. Another option is to set up an account with Upromise. The one thing I’d encourage you to look out for, though, is the “management fees” the card / 529 have. It’s possible that you’d be better off with a card that gives you cash back and that then lets you deposit the money into a savings account of your choosing.

Also, be careful that you aren’t spending more on the card “because it’s adding money to the savings fund.” Rather than spending $100 you wouldn’t otherwise be spending and having $2 go to the account, you’d be better off not spending the $100 and directly adding $10 (or whatever) to the fund.

But having a rewards card that puts money into an account is great. It’s always nice to have little bonuses for things you’d be doing anyway.

Really enjoyed this post. We have set up ESAs because of the flexibility in contributions & use. I agree that there has to be balance between saving for your own needs versus funding your kid’s college expenses. The good thing about college expenses is that many of them can be defrayed by, for example, your child getting scholarships or attending a community college for their associates degree.

I also think it’s important for families to take a good hard look at their school options. As a college administrator, I am certainly in favor of a post-secondary school education – but I think families often overlook the schools in their own back yard (state and city funded universities, community colleges etc.). Don’t get me wrong even public-funded education is expensive, but tuition costs might pale in comparison to other choices.

This is such a great post! I think the thing that always keeps me from actually opening one up for my own kids, is that they’re really young. At 4, 2 and 2 (twins in the mix) I have no idea what their future will hold. What happens if one of them never goes to college? Will that money be ridiculously taxed because it won’t be used for schooling? Can you use the money for trade schools?
I just know that while I certainly prefer that my kids go to college (my husband and I both have degrees), it’s not right to try to fit a round peg into a square hole…even if there’s money to be lost if that round peg won’t budge.

I am a tax professional and just wanted to add that 529 plans are really not the best college savings tool for the average person. They are more designed for sheltering wealth (think higher incomes, or a huge lump sum to invest). That said, they can be beneficial if you invest regularly for a long period of time (18+ years). Because they earnings are tax-free. But, most people start saving late, and they don’t really have a lot of returns to tax shelter. They can easily be paying more in fees and paying for less flexible investment choices, and these can erase any tax benefits, and even put a saver behind. I just cringe when I see 529 as the *go-to* college saving choice. I’d only recommend 529 plans to my wealthier clients. (That said, I am in a state where there is no state benefit – I might feel differently in another state with significant state tax breaks).

I totally agree with getting your own ducks in a row before saving for college. This the other point that people seem to miss- it’s hard to take care of others if you aren’t taking care of yourself first. So, good article!!

Thanks so much for your comment, Alexandria! It’s great having a tax professional’s input on it. You’re totally right, of course: the amount of time, the fees involved, and the various tax benefits of the state’s plan will greatly shape the decision.

Something else that I only mentioned in passing in the piece that’s worth revisiting: Because many 529 investments are in mutual funds made up of stocks, it’s possible for the investment to decrease before you withdraw it. For that reason, people with shorter windows of time might find that pre-paid tuition option I mentioned to be the best for them. There’s a much less likely chance that the tuition costs will go down over the next few years, even when there’s some risk that the markets might go down.

We have one anad we might contribute enough this year to get to deduct it from our state taxes but over all our plan is to try to put our kids through community college (which is a great deal where we live) and let them work their way up to higher education.

I have some questions about the account structure itself. Is the account in the parent’s name with the child as the beneficiary? Or is the account in the child’s name? Are there any special strategies for dealing with the account(s) if you have more than one child? Do you need multiple accounts or can you transfer funds between children if one child chooses a less expensive education than the other? How do you keep things “fair”? Thank you for this great article and your insight!

I’ll try to get each of the questions …
– A 529 account is owned by the parent, and the beneficiary can be anyone (but is usually the parent, a child, or a grandchild). The owner of the account (that is, the parent) is the one who makes decisions about how the account should be handled, invested, disbursed, etc.
– For more than one child, you can either open one account for each child, or just have one account that you transfer from one child to the next. One deciding factor: will the kids be in school at the same time? (Probably best to open an account for each.) Or will they go through sequentially (and not overlapping)? (You’d be okay with just one account.) Another factor: Are the parents paying for all of the school bills? Or just a portion? Those will also affect how you set them up and how you invest.
– Regarding “fairness” … that’s tricky. Lots of things go into that: scholarships, different school costs, the amount the kids are expected to contribute, gifts from other relatives, and so on. Those are the kinds of things you’ll need to talk through in your own family to figure out. (Sorry I can’t give a more straightforward answer!)

If your children are a little older, selecting a 529 or picking the funds you’d invest in with your ESA could be a really good introduction to the stock market. Even if you don’t feel like you know much about stocks, it could be a good “let’s learn this together” opportunity.

It’s also my understanding that if one of your children opts to not attend college/trade school, the 529 can be transferred to a different child, or even a more distant relative (ex: a niece of nephew). As long as the money is being used for “education” it should qualify. Is this correct?

You got it. There are a few regulations regarding transfers, but these are savings accounts that are intended to have some built-in flexibility. So transferring from one beneficiary to another isn’t complicated.

Thanks, Charlie! I have two children who will potentially be in school at the same time (overlapping for two years) and appreciate knowing that if one account doesn’t perform as well or one child opts out of school (or chooses a less expensive school), I can move money between accounts as needed. I really appreciate your clarification and guidance.

Sure thing! There’s also the option to “split” an account, but you’d want to check on that to see if there are any fees or other limitations on it. But one of the benefits to these types of accounts is their flexibility. Good luck with it!

Charlie, I am glad to know that I still love my kids! When I researched the prepaid tuition plans a couple of years ago, it seemed that only a couple of states actually let you use the money out of state. From what you wrote, that seems to be changing. Can the funds be used at community colleges and trade schools? I heard recently on the radio that more kids are opting for education at these kinds of schools, because the trades they can enter are actually paying more in this economy. Any thoughts? I am glad my sweet friend Tsh asked you to contribute!!!!

It’s always a good idea to check the specifics of the plans within your state and to see if they have any specific limitations, but I believe that, yes, any school on the list is fair game, and that includes out-of-state schools, community colleges, and trade schools.

Regarding trade schools, I’m a fan. A really good book to check out on that is Shop Class as Soulcraft. Your local library probably has a copy.

Funny thing about those 529’s and the economy- we chose not to put our money in one when they first came around, and because of the economic slump, we have no less in our savings account than we would have in a 529. All that to say, if you can’t or don’t do the 529, it might not be the end of the world.

We are blessed, I guess you would say, to live in a state that has lottery-funded scholarship and grants for state colleges and technical schools. This has allowed our kids to go to local schools for little or no cost (other than books). I have 4 kids, and all 4 have gone on this program. Unfortunately, 2 lost their scholarship due to academic standing, but it then falls on them to figure out what to do. (it can be regained).
With 4 kids, we have never considered paying for them to go to school. Depending on the situation, we may help provide some support while they are in school (money for gas, etc). And of course, in this day and age, college is not for everyone and a degree doesn’t guarantee a job.
Bernice

I have so many questions!! Thank you for this post. My husband and i have 3 kids, all 5 and under. We have a small savings, and have paid off all our debt except student loans. SO my question is: My husband just finished law school, and since he was there with young children he accumulated around 200,000 in debt (once undergrad for both of us is added in) His degree is worth it because of the huge potential for income, but still it’s going to take us a while to pay this off. Right now we live simply and throw all our extra money at the debt. Our oldest daughter will probably be in high school by the time it’s paid off. I don’t know if we should try to start saving money towards things like college (so maybe our daughters will have less debt than we do) and retirement or continue to throw all the money towards debt. I would love your input. Thanks!

There are a number of factors that’ll go into your decision, like the interest rate you’re paying on your husband’s school loans, the psychological burden you feel from carrying the debt, what kind of retirement savings (matching) you’re able to get through your husband’s firm, and so on.

Most financial advisors would probably encourage you to keep doing what you’re doing: live simply and attack the debt. At some point (again, depending on interest rates and a few other factors), you’ll want to begin saving for retirement. Until those are squared away, it’s probably best to hold off on setting aside money for your daughters’ school expenses.

I can’t recommend Dave Ramsey’s Total Money Makeover enough. I don’t agree with everything he says, but for most people, it lays out a really good plan for dealing with debt and planning for the future. It sounds like it’d be a really good book for you to look through (and it’s almost guaranteed that your library will have a copy).

This is very helpful. Do you know of any low-fee options for ESAs? We are not ready financially to regularly contribute, but have received several hundred dollars from relatives for a college fund. The fees to have an ESA through my bank are quite high. Would it be better to just keep the money in savings until we have more to contribute? Thanks!

I’m not sure what ESA options would be best for you, but a general truth about investing is that the fees tend to get cut when you’re regularly adding more. For example, USAA’s ESA (which would be one I’d consider, if I were looking for an ESA) requires $50 a month of contributions. So if you aren’t in a place to contribute regularly, it might be best to hold the money in a savings account that’s isolated from your other accounts, so the money doesn’t get absorbed by your other financial needs.

Googling “no-fee esa” brought up some results that look promising, but I’m hesitant to make specific recommendations, as I’d hate to steer you towards something with fees I hadn’t seen.

Also, it’s always a good idea to poke around at your local credit union. They often have expenses that are far lower than either national or local banks.

This is so helpful! We have 2 kids, 5 & almost 4. We opened a 529 plan for the older one 3 years ago, not the best timing, it’s finally making money but has a minimum contribution of $50/month. I’ve hesitated to open one for the younger child since I heard ESAs are “better” but I never fully understood the difference and we’re trying to pay off debt right now. I’ve also wondered what if one of them doesn’t go to college but a trade school, should I put all the money in one account but then how would I know what’s the fair split since they’ll be in school just 2 years apart. This definitely clarifies some things, thank you!

We spoke with our financial advisor about college saving and decided we wouldn’t open accounts specifically earmarked for education, just in case our two children decide not to go to college. Of course, we hope they do but we didn’t want to be penalized if they didn’t.

We ended up opening up a Mutual Fund for each of them in our names. We opened the accounts with $3k when they were 3 years old and contribute $200/month to each account. Our son is 7.5 years old, our daughter is 3.5 years old. We will gift the money to them in increments after they’ve been admitted to college OR, if they don’t choose to go to college, we will gift it when they get married and/or buy a house. Otherwise, we will probably keep it ourselves as extra retirement padding.

Thanks so much for breaking this down. I have a toddler and have been wondering if we should start some type of college fund for her. 529’s were one thing I wanted to look into, thanks for doing the leg work for me

When Dave Ramsey says to pay off debts first, does he include mortgage in that category? Our primary college plan for our kids is to frontload paying off our mortgage (we are blessed to be in year 2 of a 15 year mortgage, and we pay extra into the principal as we can) so that when our oldest is ready for school, we will be completely free of debt and able to use what we were paying help with college without touching any additional savings. As a bonus, the value of a primary residence is currently excluded from FAFSA figures.

Here’s another thought on when to begin a 529 or ESA. We are working our way through the baby steps (and we are on what Dave calls 3a, as we are working on funding an adoption right now), but have still opened a 529 for our children. Their grandparents contribute to the fund at birthdays and Christmas, and we have friends who also contribute on occasion. We see it as a win-win: we avoid getting too much ‘stuff’ for birthdays and Christmas (there were years that some of the grands gave as much as/more than Santa!) and there’s money being set aside for college even when it’s not in our monthly budget. I also love that our parents are able to contribute to something that will truly make a lifelong impact on our children – what a legacy!

One unexpected drawback to the 529 account (and perhaps the ESA as well) is that if you’re not able to pay your child’s entire tuition/housing bill with your own funds, any financial aid package is decreased when you disclose the balance in your 529 account. We had a small account for each of our four children, and I’ve ended up closing all of them in my oldest son’s first semester of college in order for him to take advantage of the financial aid available to him.

My friend has a significant amount of money in 529 and both of his kids decided to not go to college but work study. He now has a lot of money tied into a 529. While the 529 appears very helpful, it has some drawbacks.